Discipline: A Necessary Condition for Successful Investing

A good friend, Sherman Doll, related the following story. Sherman has been a two-line sport kite flier for years. While not a pro, he has learned a few tricks from observing the flying behavior of these kites. He told me that one of the most difficult skills for beginners to master is what to do when their kite starts to plunge earthward.

The natural, panicky impulse is to yank backward on the lines. However, this only accelerates the kite’s death spiral. The effective, kite-saving technique is to calmly step forward and thrust out your arms. This causes the kite’s downward acceleration to stop, allowing you to regain control and end its plunge.

What does this have to do with investing?

As you likely know, the S&P 500 Index dropped 579 points from its closing high of 2,930 on September 20 to finish at 2,351 on December 24, a price drop (not including the return from dividends) of 19.8 percent — just short of the technical definition of a bear market, a loss of 20 percent. Combined with the weak performance of global equities over the same period, the geopolitical turmoil in the world (including the risk of a trade war with China), President Trump’s attack on Federal Reserve Chairman Powell, and the shutdown of the government, many investors started to feel queasy.

Over the almost 25 years that I’ve been providing investment advice, I’ve learned that when we have situations like the one we’re in now, many investors begin to “catastrophize.” They tend to focus solely on the negative news — such as ignoring all the good economic news. For example:

Ignoring the good news, and focusing only on the market’s drop causes many investors to begin anticipating everything that could possibly go wrong, and end up in a loop of worry and anxiety that leads, at best, to indecisiveness and, at worst, to panicked selling.

Returning to my friend’s story about flying kites. Just as when a kite starts to plunge earthward and the natural, panicky reaction is to yank backward on the lines, the natural, panicky reaction to a dive in your portfolio’s value is to pull back (sell). In both cases, pulling back is the wrong strategy. The right strategy is the less intuitive one. It involves the choice to remain calm and step forward (actually buying stocks to rebalance your portfolio back to your desired asset allocation).

Perhaps the greatest anomaly in finance is that while investors idolize Warren Buffett, they not only fail to follow his advice but often do exactly the opposite of what he recommends.

Buffett’s Advice

Warren Buffett, probably the most highly regarded investor of our era, has offered the following advice over the years. Listen carefully to his statements regarding efforts to time the market.

“Inactivity strikes us as intelligent behavior.”

“The only value of stock forecasters is to make fortune-tellers look good.”

“We continue to make more money when snoring than when active.”

“Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”

Finally, Buffett recommends that if you simply cannot resist the temptation to time the market, then you “should try to be fearful when others are greedy and greedy only when others are fearful.” In other words, stick to your plan by rebalancing, which requires buying when others are panicking.

While it is tempting to believe that there are those who can predict bear markets and, therefore, sell before they arrive, there is no evidence of the persistent ability to do so. On the other hand, there is a large body of evidence suggesting that trying to time the markets is highly likely to lead to poor results. For example, in his book Investment Policy, Charles Ellis discussed a study on the performance of 100 pension plans that engaged in tactical asset allocation (a fancy term for market timing, allowing the purveyors of such strategies to charge high fees). The study found that not one single plan benefited from these efforts. That is an amazing result, as even random chance would lead us to expect at least some to benefit.

Avoiding Investment Depression

If you’re prone to investment depression, one way to help avoid the downward spiral that many investors experience (which can lead to panicked selling) is to envision good outcomes. To help you do just that, I have gone to my trusty videotape and come up with some data that should not only be of interest, but should also enable you to envision positive outcomes.

Over the last 78 years, we have also experienced four quarters in which the S&P 500 lost more than the 20 percent — the four quarters ending September 1974 (-25.2 percent), December 1987 (-22.6 percent), December 2008 (-21.9 percent) and June 1962 (-20.6 percent). Over the next 12 months, returns ranged from 17 percent to 38 percent (averaging 28 percent); over the next 36 months, returns ranged from 49 percent to 73 percent (averaging 60 percent); and over the next 60 months, returns ranged from 95 percent to 128 percent (averaging 112 percent).

There’s another way to reduce the risk of investment depression.

Myopic Loss Aversion and the Pain Ratio

Nobel Prize winner in economics Richard Thaler, author of the book Misbehaving, has found that we tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This tendency leads to the behavior known as “myopic loss aversion,” creating a problem for investors who check their portfolio values on a frequent basis. Consider the following: Based on the historical evidence for the S&P 500 Index (1950–2014), investors who check their portfolios on a daily basis can expect to see losses 46 percent of the time and gains 54 percent of the time. However, while they see gains more frequently than losses, because we tend to feel the pain of loss with twice the intensity that we feel joy from an equal-sized gain, the more often we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will be -38 ([-46 x 2] + [54 x 1]). Using a longer timeframe and more data, let’s examine how moving from daily checks to less-frequent checks affects investors’ pain/joy readings.

Over the period 1927–2014, investors who resisted checking their portfolio daily, and instead moved to a monthly check, experienced losses only 38 percent of the time. That reduced the net pain reading from -38 to -14 ([-38 x 2] – [62 x 1]).

Over the same 1927–2014 period, losses occurred only 32 percent of the time on a quarterly basis. Thus, investors who reviewed their values quarterly (like many who participate in 401k plans and receive quarterly statements) experienced a shift from net pain to net joy of +4 ([-32 x 2] + [68 x 1]).

Investors whose patience and discipline allowed them to check values only on an annual calendar year basis experienced losses just 27 percent of the time. That results in a big improvement in the net reading from +4 to +19 ([-27 x 2] + [73 x 1]).

As you would expect, the frequency of losses has continued to diminish over time. Using overlapping periods, from 1927 through 2014 the frequency of losses at a five-year horizon falls to just 14 percent. That results in a pain/joy reading of +58. At a 10-year horizon the frequency of losses falls to just 5 percent. That creates a pain/joy reading of +85 and will make for a happy (and more disciplined) investor.

If you’re a masochist, the implication for you is that you should check the value of your portfolio as frequently as humanly possible. For the rest of us, the implications are many. First, the more frequently you check your portfolio, the less happy you are likely to be and the less able to enjoy your life. Second, all else being equal, the less frequently you check the value of your portfolio, the more equity risk you should be able to take. Third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan in order to avoid pain.

The bottom line is that if you cannot resist frequently checking your portfolio’s value, you should be more conservative because you will be feeling the pain of losses more frequently. Feel enough pain, and even the most well-thought-out investment plans can end up in the trash heap of emotions.

There’s another important message here. The less you watch and/or read the financial media and the less you pay attention to economic and market forecasts (since they can cause you to imagine pain), the more successful investor you are likely to be!1

Summary

Warren Buffett has accurately stated that, “investing is simple, but not easy.” The simple part is that the winning strategy is to act like the lowly postage stamp, which adheres to its letter until it reaches its destination. Similarly, investors should stick to their asset allocation until they reach their financial goals.

The reason investing is hard is that it can be difficult for many individuals to control their emotions (greed and envy in bull markets and fear and panic in bear markets). In fact, I’ve come to believe that bear markets are the mechanism by which assets are transferred from those with weak stomachs and without an investment plan to those with well-thought-out plans — meaning they anticipate bear markets — and the discipline to follow to those plans.

A necessary condition for staying disciplined is to have a plan you can adhere to. But that’s not sufficient. The sufficient condition is that you must be sure your plan avoids taking more risk than you have the ability, willingness, and need to take. If you exceed any of those, you just might find your stomach taking over. The bottom line: If you don’t have a plan, develop one. If you do have one, and it’s well-thought-out, stick to it.

1 There is no guarantee that the strategies set forth in this presentation will achieve their intended objectives.

Larry Swedroe

Director of Research

Larry Swedroe is director of research for Buckingham Strategic Wealth, Loring Ward, and the BAM ALLIANCE.
Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.
To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need.